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December 6, 2013

Don’t Break Our Thriving 401(k) System, Groups Urge Government

Olivia Mitchell weighs in on study by three benefits groups calling 401(k)s a success and urging tax reformers to stay away

Wharton professor Olivia Mitchell.

Much of the criticism of the U.S. retirement system is misguided, a joint report released by the American Council of Life Insurers (ACLI), American Benefits Council (the Council) and Investment Company Institute (ICI) said.

The paper, released Wednesday, said that employer-sponsored retirement plans were a vital source of retirement security for American workers and that government proposals to change their tax treatment would thwart efforts to save.

The authors studied research and surveys from various sources dating as far back as 1975 for the paper, “Our Strong Retirement System: An American Success Story.” The authors illustrated the strength of the retirement system as a pyramid. Social Security forms the base of the pyramid. It supports homeownership, employer-sponsored plans and IRAs. Other assets form the top of the pyramid.

The authors noted that overall retirement well-being has improved over time. In 1975, when the Employee Retirement Income Security Act took effect, household retirement assets were just over $27,000, adjusted for inflation. Now they are six times higher at nearly $168,000. Between 1975 and 2011, both the number of retirees with private retirement income and the amounts they were receiving increased.

The paper argued, too, that income remains stable in the first few years of retirement. Data from the Internal Revenue Service’s Statistics of Income Division shows income from wages, Social Security, retirement plans and IRAs remained stable through the year that retirees filed for benefits and the three years following.

“Our private retirement system has come under attack from those who seek to radically change it or replace it with government-backed programs,” Walter Welsh, executive vice president of taxes and retirement security for ACLI, said in a statement. “As employers and organizations committed to helping Americans save for retirement, we believe that such changes would be extraordinarily risky for the majority of workers who rely so heavily on these plans.”

Defined contribution plans have proliferated in recent decades as defined benefit pension plans have waned. DC plans' flexibility leaves room for further innovation, too, according to the paper. “Defined contribution plans are not just ‘working,’ they are strong,” the paper stressed.

Olivia Mitchell, a professor at the Wharton School of the University of Pennsylvania and executive director of the Pension Research Council, agreed that defined contribution plans are better suited for today’s employees who frequently change jobs, and noted that defined benefit plans’ heyday wasn’t necessarily the golden age it’s remembered as.

“What many people don’t understand is that the traditional defined benefit pension plan environment was a golden age for a few, but not for many,” she told ThinkAdvisor on Friday. “Under the typical defined benefit plan, you only really got a useful benefit if you remained there your entire career. You had to have 30 or 40 years of service before you would get a nice payout. Most people don’t understand that only one out of 10 employees who start working in a company with a DB plan ever gets a benefit from it. If you change jobs, if you drop out for a while to go to school, if you stay home with kids, if you have a sick elderly parent and have to leave a job, then a DB plan doesn’t really suit you. The defined contribution plan is a much better model in principle for the kind of work force we have today.”

The paper argues that because 401(k)s were only introduced in the 1980s, workers haven’t had an opportunity to “[enjoy] the full benefits of the many innovations and improvements reflected in today’s 401(k) plans.” Current retirees and those about to retire worked some part of their career in the pre-401(k) era, and workers who are young enough to have started saving in a 401(k) are many years from retiring.

Criticisms of 401(k) plans come down largely to missteps in evaluating their success, according to the paper. Analyses often come up with averages for an entire population of workers without considering their income, age or length of time in the plan. They frequently exclude other savings as well.

The paper referred to data from the Employee Benefit Research Institute that found workers in their 60s who had been with their employer for at least 30 years had an average $208,892 saved in their 401(k) as of the end of 2011. The average balance for all participants was under $59,000. A 2013 analysis by Fidelity Investments of almost a million investors who had more than one type of retirement savings account held there put the average combined balance at $225,600 by the end of 2012. Average balances rose from more than $32,000 for workers between 25 and 29 to almost $448,000 for those in their early 70s.

However, Mitchell noted that many projection studies, both industry and academic studies, fail to take into account the effect of Social Security and Medicare.

“What might look like sufficient retirement savings if we can count on Social Security and Medicare probably won’t be if benefits have to be cut a lot,” she said. “Then of course we’re also living longer than we did 50 years ago, so there are more years over which we have to spread those retirement assets.”

She added that retirees can’t really predict their future medical care needs, either. “By one estimate, if you wanted to prefund your out-of-pocket premiums for Medicare and deductibles and copays and so forth, as well as put aside the amount you’d need for long-term care, a couple could easily need to have something like $500,000 — just to pay for medical costs. What that means is if you have $1 million, half of it will go to medical and you’ll have to live on the other half to pay your bills, travel, buy your grandkids presents. What used to look like a lot of money doesn’t anymore.”

“I wouldn’t say the picture is all good or all bad," Mitchell added. "I would say the pension institution we have now seems to be better suited to most of our workers in the current economy, and in other countries as well.”

Americans’ high level of confidence in 401(k)s is another tick on the positive side of the ledger. Almost two-thirds of households surveyed by ICI, and 76% of households who had a DC plan or IRA, said they had a very or somewhat favorable impression of those types of plans.

Also key to 401(k) plans’ success is their tax-deferred status. However, the paper stressed that a tax deferral is not an exclusion or deduction. They are similar in that they reduce taxes paid in the year of deferral, but they increase taxes at distribution because taxes are paid on the original deferred compensation and the interest earned, according to the authors. “The benefit of tax deferral is the combined effect of tax savings at the time of contribution and tax savings on investment returns, reduced by the tax paid on distributions.”

The paper said several current tax reform proposals would affect retirement plans’ tax status, effectively weakening their success. One such proposal would replace the current system of deductions and exclusions in income taxes with flat-rate refundable credits. Another proposal caps itemized deductions at 28%.

A 2010 proposal by The National Commission on Fiscal Responsibility and Reform limits combined employer and employee contributions to $20,000 or 20% of compensation, whichever is less. The paper noted that “A $20,000 contribution limit in 2013 would be less in nominal dollars — without allowing for inflation — than the 1975 limit of $25,000 established by ERISA.”

“A lot of evaluation of reforms tends to be driven by need for tax revenue,” Mitchell said. “In times of fiscal stress, governments are very reluctant to allow money to be set aside in tax-deferred accounts because it makes the current budget shortfalls look worse. Of course, sooner or later the government gets the money back because when you withdraw the funds you pay income tax on them. They don’t take into account the fact that more saving now will generate more income later. Part of the appeal of trying to raise taxes or curtail retirement spending depends on this artificial window, which I don’t much approve of.”

A 2012 study by Mathew Greenwald & Associates showed the effect those proposals might have on employers’ willingness to offer the plans, according to the paper. A flat-rate tax credit of 25% would lead almost half of employers to drop their plan or at least consider doing so. A 28% cap on exclusions would force 35% of employers to drop or consider dropping their retirement plan, the same percentage who would react negatively to the 20/20 proposal.

Among respondents who would keep their plan, 30% would cut non-elective contributions, 29% would cut employer matches, and 23% would lower auto-enrollment, auto-escalation and safe harbor contributions.

“Congress is currently contemplating comprehensive tax reform, and we want policymakers to understand the importance of the private retirement system and the role of tax deferral in promoting retirement savings and retirement security,” Lynn Dudley, senior vice president of retirement and international benefits policy for the American Benefits Council, said in a statement. “Lawmakers will find evidence in this report that efforts to raise money by reducing the tax incentives for retirement plans are short-sighted and illusory — and could ultimately decrease retirement savings, especially for low-income workers.”

Mitchell said that determining how much to save is closely tied to what you think interest rates will be in the future. With more pessimistic estimates for returns at between 2% and 3%, Mitchell said, target savings goals should be around 25% of annual salary. “In reality, focusing on the low savings we’ve had in the past, we need to be encouraging rather than discouraging more saving.”

There are some proposals that could have a positive effect on savings, though. Mitchell said, “There have been proposals to have automatic 401(k)s or Australian-style pensions. In Australia they have a 9% of pay mandatory contribution rate. Moreover, the Australians have decided to bump that to 12% of pay. In the U.S., in typical 401(k) plans, we’ve seen numbers like 3% or 6%. We have a long way to go before we hit anywhere near the maximum.”

Other proposals have been floated to “de-link” 401(k) plans from employers, Mitchell said, that would allow people to have an automatic payroll deduction into an IRA. This would be especially helpful for workers at small firms that don’t offer 401(k)s to their employees.